Article excerpt

The financial crisis of 2007-09 is widely viewed as the worst financial disruption since the Great Depression of 1929-33. However, the accompanying economic recession was mild compared with the Great Depression, though severe by postwar standards. Aggressive monetary, fiscal, and financial policies are widely credited with limiting the impact of the recent financial crisis on the broader economy. This article compares the Federal Reserve's responses to the financial crises of 1929-33 and 2007-09, focusing on the effects of the Fed's actions on the composition and size of the Fed balance sheet, the monetary base, and broader monetary aggregates. The Great Depression experience showed that central banks should respond aggressively to financial crises to prevent a collapse of the money stock and price level. The modern Fed appears to have learned this lesson; however, some critics argue that, in focusing on the allocation of credit, the Fed was too slow to increase the monetary base. The Fed's response to the financial crisis has raised new questions about the appropriate role of a lender of last resort and the long-run implications of actions that limit financial losses for individual firms and markets. (JEL E31, E32, E52, E58, N12)

**********

The financial crisis of 2007-09 is widely viewed as the worst financial disruption since the Great Depression of 1929-33. The banking crises of the Great Depression involved runs on banks by depositors, whereas the crisis of 2007-09 reflected panic in wholesale funding markets that left banks unable to roll over short-term debt. Although different in character, the crisis of 2007-09 was fundamentally a banking crisis like those of the Great Depression and many of the earlier crises that preceded large declines in economic activity (Gorton, 2009).

Table 1 reports information about every U.S. recession since the Great Depression of 1929-33--more specifically, the periods designated as economic contractions by the National Bureau of Economic Research (NBER). The recent recession began in December 2007, according to the NBER. Although their Business Cycle Dating Committee has not officially identified the end of this recession, many economists believe that it ended in the middle of 2009; thus, the data used for this recession span December 2007 through June 2009.

In terms of duration, decline in real gross domestic product (GDP), and peak rate of unemployment, the recent recession ranks among the most severe of all postwar recessions. (1) However, the recent recession was mild compared with the economic declines of 1929-33 and 1937-38. For example, real GDP fell 36 percent during 1929-33, and the unemployment rate exceeded 25 percent. Moreover, the price level, measured by the consumer price index (CPI), fell by 27 percent. By contrast, the CPI rose 2.76 percent between December 2007 and June 2009.

Monetary, fiscal, and financial policies are widely credited for limiting the impact of the financial crisis of 2007-09 on the broader economy. In nominating Ben Bernanke for a second term as chairman of the Board of Governors of the Federal Reserve System, President Obama credited Bernanke with helping to prevent an economic freefall. (2) Chairman Bernanke (2009c) has also cited "aggressive" policies for insulating the global economy, to some extent, from the financial crisis. Bernanke noted that, in contrast, monetary policy was "largely passive" during the Great Depression.

This article summarizes the Federal Reserve's response to the financial crisis of 2007-09 and compares it with the Fed's response to financial shocks during the Great Depression. First, the article describes the Fed's actions as the recent crisis evolved. Initially, the Fed focused on making funds available to banks and other financial institutions, but used open market operations to prevent lending to individual firms from increasing total banking system reserves or the monetary base. …